Custom «Risk Management: Credit Risk-2007» Essay Paper

There are numerous risks that are inherent in many operating organizations in the global markets, and more specifically in the financial institutions. At the current business operation environment of stiff competitions, the financial institutions are greatly exposed to huge risks unlike the way it used to be many decades back when regulation were less implemented. Today, financial organizations face many challenges, some of which are financially related whiles others are non-financially attributed. This implies that uncertainties or risks are inseparable events in the banking sector. Risks being integral part of the financial organizations are categorized into three or so major groups: Market, operations and credit risks. The success of any financial institution that is involved in business operation depends on the leveraging of the various mentioned risks (Bank of Japan 2010).

Precisely, it is observed that business expansion occurs through taking of risks, and further, the higher the risk, the more the returns the risk taker expects. However, in order to achieve the business goals and purpose of profitable operations, risks ought to be controlled. Thus, risk management has got a significant meaning in the maintenance of the organization's operations in the right track. Among the three kinds of risks: market, credit and operational risks, financial experts believes that credit risks is the most sensitive to organizations particularly those in the financial sector. The implication on this that risk management on credit risks and any other sort of risk is crucial for the safe guarding of the healthy operations in the financial institutions. This is posited as an enabling step that assures measured solvency of the financial corporations (Bank of Japan 2010).

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Background of 2007 financial crisis

The financial crunch in 2007 has widely and extensively been researched and discussed, with many results of the work showing diffused causal factors of the recession. In one group of thought, they believe that the main cause of the financial crisis emanated from the financial lending institutions on mortgages. The negative effects of financial crisis began in the decline of the lending tendency by most of the creditors. As the problem crouched in, it was more or less localized affecting just a few of the financial institutions. The emerging depressing effects were first felt by the small and medium size firms indiscriminative of the sector or industry they belonged. This was attested in many regions including the areas which are predominantly considered as drivers and market leaders in the global markets (Corrigan, G. et al 1999).

In the verge to the encroachment of the financial crisis, researchers and other specialists reported a change in the lending for most of the highly depended creditors, and there was a general problem from most of small sized financial institutions. However, these experiences of the negatives effects were broadly distributed affecting not only small scaled organization, but also greatly depressing environments were definitely felt in major corporations. For instance, in 2007, chief corporations including the U.S.A main housing creditor had indicatively shown that lending had declined at very high rate. Furthermore, a few of the corporations which had long history in loan disbursement such as the New Century financial corporation had been declared bankrupt (Corrigan, G.

The lending institutions reported unprecedented borrowing of from their organization more certainly in housing and building industry. However, there was a total lack of balance on the lending and depositing in the financial institutions. By 2007, deposits from clients drastically had decreased, recording an estimated decline ranging from about fifty to seventy percent in the corporations. Similarly, the banking industry trends had a marked difference on its performances. As unveiled in the numerous information sources, most of the banking firms laid-off considerable number of their employees, and in severe extents, a few of them were denounce bankrupt. The UBS, a Swiss investment exemplifies those banking institutions which collapsed in 2007 following the financial crunch. The IKB and the BNP banks based in the European countries also followed suit due to the similar negative operational consequences (Bank of Japan 2010).

The emerging of the financials crisis was indicated by several factors which are determinants of the nature of lending risks in the financial organizations. First, the interest rates decreased rapidly at the international markets. Such experiences were well portrayed in both the United Kingdom and United States markets. It's said that in August, 2007, London and New York markets saw interest rate surge at unprecedented rate. The lending tendency declined not only between banks but this trend was also shown to the consumers at the grass roots. In the European markets, the surge in the interest rate implied shortage of the finances for loans.

Analysts based on economic and financial matters posited that the financial crunch in 2007 could not be blamed on firms/ corporations based on a particular industry. However, they mostly emphasized that the source of the financial crunch as base on the housing lenders and the banking institutions. Concerning such, numerous arguments by international financial analysts posited that the greatest problem that led to the financial menace is what they referred as counterparty risk practices. This meant that majority of the banking institutions were less willing to extent credits to other banks. Moreover, the fear to extent the credit to banks was a measure of limiting the number of default losses on loans as it was perceived of the high risk in the market (Kohn, 2010).

Generally, the banking institutions on the perception of the Impending risks in the sector, they changed their ordinary operation to accommodate the perceived future changes. In doing so, the banking corporations provided paths that in one way were key contributing factors to the financial crunch. The banking corporations though declined from lending practice in 2007, they began practicing more lax methods. Initially, evading risks a matter of great concern and therefore, the commenced on off-loading of the risks through collection of the loans on those organizations with good credit reputations. Additionally, many of the banks initiated internal funding of their company's projects based on risky instruments. The implication of such is that banks are not exclusive of the causal factors of the financial crisis, but they have eminently contributed to the collapsing of the global economy (Bank of Japan 2010).

Management of risks

In the broad sense, it had been established that the 2007 global financial crisis had been caused by several factors.

Among the many causal factors of the current financial crisis are attributed to the lack of sound and empirical principles for the risk management in the banking industry. It is also noted that most of the financial institutions have developed a tendency of diverting from the already established principles. This habitual practices whereby the banking institutions operates without appropriate guiding principles or strict adherence to the operating principles, policies or regulations have been so detrimental to the banking organizations and the banking industry as whole. These particular practices have great influence in the banking institutions as far as risks on credits are concerned (Kohn, 2010).

As the monetary institutions such as banks continued to grapple with the conditions of financial shock, a number of control measures were taken. A part from the normal lending regulatory procedure, numerous banking institutions formulated and embraced extra control measures on extension of financial credits to its clients. Generally, with the realities of the falling of global economy, most of the banking corporations began to avoid lax lending by putting stringent restrictive measures in their operations. First, the deterioration of the global economy compelled some of the banking institutions to raise their lending standards. They raised the basic minimum requirements including client's annual minimum balance on financial statements. By doing so, the banks cut off most of the small and medium enterprises that were likely to cause high default losses in the banking industry. The raising of the minimum requirements and standards helped the banking institutions to evade not only direct default loan losses, but these measures greatly helped in the protection of the organizations from increased operational costs. The banks imposed security guarantees requirement on loans which in the earlier did not require a guarantee. This measure further eliminated many clients seeking financial aid without firm base of repayment process. Basically, this kind of policy implementation had been practiced both in the small micro-financial institutions as well as by the major ones not excluding the interbank lending systems. All in all, the managerial team had to take these stun step to reduce the risk position of the organizations (Bank of Japan 2010).

Though many of banking institutions faced the challenge of liquidity, they had a number of ways in which to deal with this issue. Banks applied assessments procedures in the lending process in the same way they have been in the past periods. The employment of such methodologies has raised wide controversial views; hence, while the banking institutions used to strengthen the restrictive measures on the application process, some of the strategies that were used in the extension of the financial aids had conditions that were questionable. It was observed that banks still used the information from rating agencies in the determination of potential clients for loan disbursement. It's however established that many of the special rating institutions develops their own interests depending on the form of the businesses. That would mean, most of the information revealed on the rating reports might not have reflection of the actual financial stability of the bank's client. Consequently, the banking organizations were being exposed to greater financial risks of default loans in the similar way they used to operate prior to encroachment of the financial crunch (Kohn, 2010).

The issue of financial crunch had triggered the consideration of many factors involved in the risk management. The structure of the organizations is among the many determining factors of the degree of evading or reducing the financial risks of an organization. This is considered at two different levels, first the internal and then the external organizations of the financial institutions. In this new era of technology, it was noted that most of the financial organizations are integrated in numerous ways. The integration of the different financial institutions thus accelerates the tendency of borrowing and lending of financial aids. This is likely to drain the liquidity stock for most of the organization lacking sound principles in risk management. The effects of financial crunch were largely escalated by the organization of the banking institutions. Overtly, the major banking institutions in the key financial market have existing foreign banks, which are either parallel-owned institution or affiliated ones. The most appalling problems with this kind of integration are that it's hard to established adequate supervision programs on the parallel-owned organizations in those foreign nations. Some of the banks are affected by the political factors in those foreign states while others are affected merely by the general status of the country's economy (Corrigan, G. et al 1999).

In the U.S, the escalation of the financial difficulties in 2007 in the micro-financial institutions was as a consequence of the regulatory measure of central banks. While the small and medium financial institutions operated under the control/checks of the central banks, any emerging change of policies and regulations within the central banks directly and indirectly affect them. During the 2007 financial crunch, the U.S central banks increased the percentages of reserves for the depository financial institutions. Increasing of reserve percentages definitely caused draining more of the funds that were being held in the depository institutions to the central banks. A part from the central banks draining the liquidity stocks held by the small and medium financial corporations to their custodies, they also increased the discount rates so as to maintain a healthy liquidity stock above the normal. Though the increase in the discount rate in a way safeguarded the central banks from running out-of liquidity stocks, this acted as barrier to borrowing for those financial institutions which depended on them for financial aids. Either the limiting of the access to the central bank led to a chain of similar reactions compelling the financial institutions in difficulties due to lack of liquidity stock to keep operating at unprofitable market. As the depository commercial banks became squeezed to a greater extent, they alternatively turned to conversion of the capital assets into to liquidity stocks. Undoubtedly, trading on capital assets is more risky to operating unprofitably as productivity is mostly affected together with augmented difficulties in meeting the organization's obligations of current debts and operational costs, and thus, such strategies would definitely lead to insolvency of affected financial institution (Bank of Japan 2010).

Furthermore, the Federal Reserve worked closely with some of the financial organizations and the government organ, the treasury to mitigate the financial crunch situation. However, the corporation of these bodies to some extent was considered as unhealthy in commercial financial trading. For instances, it was revealed that the Federal Reserve participated actively the acquisition process and safeguarding of the certain financial institutions. The Federal Reserve acquired the Bear Stearns bank in the time financial recession, offering the organization an opportunity for acquiring liquid stocks including securities among others. Under the consideration of equality in business environment, this act is considered as a flaw by promoting easy financial accessibility to a few companies (Kohn, 2010).

Role of the ECB

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The ECB had enormous obligations of alleviating the complexity and weakness found in the financial institutions. First, through its reporting on the credit assessments, the ECB performed its independent probing in which emphasize was put the security asset provided by the institution seeking financial aid. The ECB gather its information from other specialized agents, which showed their thoroughness leading to elimination of loan extensions that might definitely default, or denying eligible debtors. Further, the ECB advocated for establishment of minimum liquidity policy within the banking institutions.

Significance of the financial crisis

Though the financial crisis had caused a lot of detrimental negative effects of unprofitable operation in almost all the banking and financial institutions, this probably obscured the benefits of it. However, there are several positives that are accrued from the financial crisis of 2007. The resulting effects of the financial crunch depicted many flaws and unprepared-ness in the regulations of monetary flaws within the financial institutions. First, the raising of the Federal reserves, and discount rate depicted that the central bank's lack of adequate policy and regulatory procedures within its financial systems. The realization of the subtle policies in places would help the financial industry in the formulation and implementation sound policies and regulation that would aid in the stabilizing the industry by acting in a proactive way rather than acting in a reactive manner in the future. In order to achieve this particular goal, the central bank will have to put in place policies that would optimize liquidity stocks in the financial systems. Adjustments in the central banks are most crucial in the endeavor of curbing the problem or effects of financial shock within the financial industry as changes made within these organizations affects the entire financial systems. Having the right liquidity in the central banks together with adherence to the set policies therefore proves sufficient in maintaining healthy liquidity at the depository banks.